COVID-19 retreats
COVID-19 cases and hospitalizations are in retreat across much of the world
(see next chart). Even Japanese infections – which had recently surged
to record levels – are now in precipitous decline (see subsequent
chart).
COVID-19 cases are in retreat
COVID-19 cases and deaths in Japan are falling after record levels
Happily, two Omicron-targeting vaccines have been approved or are in the
process of being approved, depending on the jurisdiction. These should be
significantly rolled out over the coming months, providing additional
protection and hopefully preventing any winter wave from inflicting too much
damage.
Further, it is promising that no new variants have yet emerged to displace the
currently dominant BA.5 Omicron sub-variant. It is still prudent to assume
there will be future waves driven by new, more contagious variants (or even by
waning immunity to BA.5). However, the waves did eventually end for the
Spanish Flu.
China remains the exception to this positive COVID-19 narrative. Its
zero-tolerance policy has most recently ensnared Chengdu, a city of 21-million
people. The city has been put on indefinite lockdown. In fact, according to
CNN, more than 70 Chinese cities have been put under a full or partial
lockdown since late August, affecting more than 300 million people. This may
be a particularly vigilant push in the lead up to the National Congress that
takes place on October 16. It is plausible that restrictions could ease
thereafter, but that is mere speculation.
Ukraine attracts
Ever since Ukraine rebuffed a portion of Russia’s initial assault in
late February, Russian forces have been nibbling away at Ukrainian territory.
That trend appeared to reverse over the past week, as Ukraine reclaimed a
chunk of its land in the east of the country, near the city of Kharkiv.
It still seems reasonable to expect Ukraine to gradually achieve the upper
hand given the ongoing supply of western weaponry versus the gradual
diminishment of Russian stocks. However, this is far from certain and the war
is likely to persist for quite some time. Sanctions should endure for even
longer – the observation of greatest relevance from an economic and
inflation standpoint.
Russia is now effectively sanctioning itself with regard to the sale of
natural gas, having steadily reduced its provision of the commodity to Europe,
and cutting it off altogether in early September. Natural gas prices surged
another 30% on this news. At current prices, the European Union is on track to
spend seven times more on electricity and gas than normal over the coming
year.
Reflecting the altered energy landscape – the diminished reliability of
Russian supplies combined with the mounting importance of securing domestic
energy security – Japan has announced it will return to nuclear power
after shunning the technology over the eleven years since the Fukushima
nuclear disaster. The government aims to revive 17 out of its 33 operable
nuclear reactors by next summer.
Inflation snippets
We begin with a refresher of key inflation views, before proceeding in several
granular directions.
North American inflation appears to have peaked in June, softened in July and
should be muted again when the August data becomes available. While it is
unlikely that monthly price changes will remain quite that limp, we
nevertheless budget for generally diminishing inflation pressures ahead, based
on the view that all four of the key drivers of high inflation have turned:
- Monetary stimulus has become monetary restraint.
-
Fiscal stimulus has similarly become a fiscal drag despite recent new
initiatives.
-
Supply chain problems are significantly resolving (more on that later).
-
The commodity shock – ex-natural gas – has materially unwound.
Inflation scenarios
The most likely scenario is that inflation diminishes over the coming six
months, approaching – if not quite fully reaching – a historically
normal monthly rate of change. But this forecast, as reasonable as it is, is
not the only conceivable scenario (see next graphic).
U.S. inflation scenarios suggest return to normal
We assign a 55% chance to this base-case scenario, alongside a 20% chance that
inflation remains too high. Technically, this is split into a 10% chance that
inflation remains at current levels and a 10% chance that it ascends further.
There is also a 25% chance that inflation falls below normal.
The existence of a low inflation scenario might be surprising –
particularly the notion that it is more likely than the scenario in which
inflation remains too high. But with the commodity shock and supply chain
problems unwinding, there could be not just a retreat in price pressures but
an outright reversal as the underlying cost of shipping products and procuring
goods reverses some of their earlier advance. Recessions usually bring
powerful disinflationary forces as well.
A key goal in this scenario-building exercise is to explicitly acknowledge the
low inflation scenario, as it is underappreciated.
As depicted in the graphic above, we also contemplate the medium-term
inflation outlook. This should be interpreted as representing inflation in one
to two years’ time. We believe there is an 80% chance that inflation
eventually settles at a broadly normal level (though allowing for the
definition of normal to include inflation up to about 3%). That leaves a 10%
chance that inflation remains enduringly too high, and a 10% chance that
inflation remains enduringly too low. The former scenario represents the
failure of central banks or the arrival of additional inflationary shocks. The
latter scenario would reflect a deeper recession and/or a stronger tendency
for distorted prices to retreat back to their prior levels.
European gas subsidies
European governments are recognizing that households, businesses and certain
power companies cannot be forced to fully absorb skyrocketing natural gas and
electricity prices. A range of measures have thus been implemented to shift
the burden from the private sector to the public purse:
-
Germany has now implemented three energy support packages, collectively
costing 95 billion euros.
- The French relief package is expected to cost 64 billion euros.
- Italy is thought to have already spent 52 billion euros.
-
The U.K., under new Prime Minister Liz Truss, has promised to freeze energy
costs for two years, to the tune of 100 billion pounds.
These actions have several important consequences.
-
They limit how high consumer prices will rise, since those prices are now
being artificially capped in several countries. As such, for instance, the
U.K. annual Consumer Price Index (CPI) no longer appears likely to reach the
high teens, though Europe and the U.K. will still likely suffer through
higher inflation than North America in the near term.
-
Some governments are looking into placing temporary windfall taxes on energy
companies that are profiting from high energy costs. This would discourage
investment in future capacity, but help to pay for the energy subsidies.
-
Fiscal deficits will be significantly larger than before due to these
initiatives, at a time when quantitative-easing operations were already
coming off. That would suggest, all else equal, higher yields.
-
Direct subsidies are a flawed solution in that they don’t incent
people to use less energy. And without that, the energy shortage could be
quite serious indeed over the winter. A better solution would be rebates
unconnected to actual energy usage, or capped at a limited level of energy
usage, that reward people for cutting back.
-
More support is likely in future years. To the extent it may take several
winters for Europe to fully shift its energy consumption away from Russia
and natural gas, there will be pressure for these programs to be extended
for years. The U.K. is already promising support for two winters. This adds
to the cost.
-
At least so far, most European countries remain firm in supporting sanctions
despite Russian pressure. An exception is Bulgaria, which is thought likely
to strike a deal with Russia.
Shelter inflation
The shelter component of inflation continues to run hot, even as housing
markets begin to cool. This is not a new phenomenon: the shelter part of the
Consumer Price Index (CPI) is famously lagged relative to the housing market.
A recent White House report estimates that it takes 16 months for a turn in
home prices to be picked up in the owner’s equivalent rent portion of
shelter costs in CPI. To the extent that the U.S. Case-Shiller home price
index hasn’t even begun to really turn, this suggests that shelter will
remain a source of heat for some time to come, though it should eventually
cool. When it does start to cool, it should remain a disinflationary force for
an extended period of time.
In Canada’s case, the lag should be somewhat less. Not only have
Canadian home prices already been falling for six months, but dwelling costs
are incorporated into Canadian CPI in a way that should render them somewhat
less lagged. Still, a substantial lag remains: the owned accommodation portion
of Canadian shelter costs has only decelerated slightly so far.
U.S. regional variations in inflation
Inflation is not the same everywhere within a country. In the case of the
U.S., it is interesting – and logical – to note that the lowest
inflation has been in the Northeast, whereas the highest inflation has been in
the South. Loosely, this aligns with where Americans have moved from and to
during the pandemic. With a rising population home prices rise by more, the
economy runs hotter and products are in shorter supply. All of this is
inflationary for the South.
There may also be a non-pandemic structural element at play since the
Northeast has been losing population share to the South and the West for many
years.
Northeast inflation is running 1.2 percentage points below the U.S. average.
South inflation is 0.9 percentage point higher. The West and Midwest land in
the middle.
Shrinkflation investigation
Shrinkflation is a sneaky kind of inflation in which the size of a product
subtly shrinks rather than the price of the product rising. Naturally, it is
more common during times of high inflation as companies become desperate for
ways to pass along rising input costs.
Recent examples include the size of a Gatorade bottle shrinking from 32 ounces
to 28 ounces (equating to a 14% price increase) and Domino’s Pizza
reducing its chicken wing order from 10 pieces to 8 pieces (a 25% price
increase). These changes happen most frequently in the food and drink space.
Shrinkflation is undoubtedly sneaky and means that inflation is higher than it
appears to be for the average person. However, contrary to what one might
imagine, it is already properly captured in consumer price indices (CPI). CPI
is already measured on a per unit basis where possible, so this extra
inflation does appear in the official estimates.
Under normal circumstances, the magnitude of the shrinkflation effect on
inflation is small. A pre-pandemic U.K. study could only find a significant
effect for confectionary items and identified a mere 1.2 percentage point
cumulative effect on the sector’s prices over a five-year span. Mapped
onto the overall consumer price index, shrinkflation contributed just 0.03
percentage points to inflation over the period. One imagines the effect is
several times that today, though the resultant sum would still be fairly
small.
Complicating matters, sometimes a company reduces the size of its product but
claims that rising quality fully offsets the change. For example, Folgers
coffee reduced its standard container from 51 ounces to 44 ounces, but insists
that the quality increased proportionally, such that 400 cups of coffee can
still be brewed from the container. This deflationary effect would not be
captured in CPI.
The lesser-known service sector equivalent of shrinkflation is called
skimpflation. An example is that, post-pandemic, hotel rooms no longer receive
housekeeping service every day. One might also argue that the provision of
online education and online health care during the pandemic was of a lower
quality than the in-person equivalents before the pandemic. But the cost did
not generally decline, meaning there was extra inflation. Unlike with
shrinkflation, statistical agencies do not have a mechanism for adjusting
their inflation estimates to account for skimpflation. As such, some service
sector components likely have inflation rates somewhat higher than officially
registered.
Supply chain inflation
Inflation deriving from supply chains should reverse as supply chains
themselves heal. Examples of important improvements include plummeting
container shipping costs (see next chart), a return to nearly normal dry bulk
shipping costs (see subsequent chart) and a sharp decline in the anxiety of
manufacturing purchasing managers about both inflation and their supply chains
(see third chart).
Shipping costs fall further
Shipping costs retreat from latest peak
Price increases and supplier deliveries returning to normal ranges
Second-round inflation pressures
As the primary drivers of inflation turn, a key remaining question is the
extent to which second-round inflation pressures will pick up their mantle and
keep inflation roaring. Three key considerations are the breadth of inflation,
wage pressures and inflation expectations.
-
With regard to inflation breadth – the extent to which a lot of
different products are becoming more expensive – the news is still
grim. The breadth of high inflation again increased (slightly) in July.
Inflation was softer in July for a very narrow reason: the decline in
gasoline prices. The breadth of high inflation still risks high inflation
becoming self-perpetuating.
Inflation in the U.S. has broadened significantly
-
Wage pressures may be starting to turn downward. Overall U.S. wage growth
has ebbed only slightly, but the bellwether limited-service restaurant
sector has experienced a sharp deceleration in wages (see next chart). This
sector includes fast food restaurants, which employ lower skilled workers
who are the last to be hired and the first to lose their bargaining power as
labour markets sour.
Wage growth of U.S. low-skilled workers decelerating
-
Inflation expectations continue to ease. While financial market-based
inflation expectations declined some time ago, main street inflation
expectations were more reluctant to drop. For inflation to sustainably
decline, businesses and households need to be convinced as well.
Fortunately, there has recently been a palpable if small drop in business
inflation expectations and a slight decline in consumer inflation
expectations (see next chart).
U.S. inflation expectations have started to fall
Further emphasizing that businesses are starting to think differently about
the inflation outlook, the fraction of U.S. businesses looking to raise prices
has begun to descend from record levels (see next chart).
Fraction of U.S. businesses planning to raise prices still high but falling
Economic developments vary widely
Recent U.S. economic data has not been bad:
-
The Institute for Supply Management (ISM) Manufacturing index for August
held steady at a so-so 52.8.
- The ISM Services measure rose from 56.7 to a solid 56.9.
-
U.S. payrolls for August added a further 315,000 jobs, dampened only slightly
by a -107,000 negative revision to prior months and a small increase in the
unemployment rate from 3.5% to 3.7%.
-
Initial jobless claims have also fallen for the last three weeks, albeit
after a longer and larger increase over the prior few months.
-
U.S. Q3 Gross Domestic Product (GDP) is now tracking a 2-3% annualized gain,
suggesting a recession is not yet underway.
The story in Canada, in contrast, is considerably worse. For instance:
-
The Canadian job market shed workers for a third consecutive month (see next
chart), losing 39,000 overall positions and 77,000 full-time ones.
- The unemployment rate accordingly rose from 4.9% to 5.4%.
-
Although there is some suspicion about the seasonal factors affecting
certain sectors – it is hard to fathom that 50,000 Canadian education
workers actually lost their jobs in August – there is a tinge of truth
in other areas. Construction employment fell by 28,000 at a time that the
Canadian housing market is weakening.
Canadian labour market shows sign of weakness
The Canadian economy has also lately been stumbling. After recording a month
of flat economic output in May, June notched a muted 0.1% gain and July is
tracking -0.1%. That is effectively a quarter without economic growth.
Soft versus hard data
“Soft” economic data in the U.S. – surveys and the like
– have weakened quite a lot, whereas “hard” economic data
– measures of actual spending and hiring – have not descended to
the same extent (see next chart).
Both hard and soft economic soft data in U.S. turn negative
The most likely scenario is that the hard data eventually follows the soft
data, fulfilling the recession prophecy. Indeed, it is logical to think that
sentiment and expectations should drop before actual activity declines. But
one cannot completely rule out the “soft landing” scenario in
which weak sentiment never fully translates into poor spending and hiring. The
pandemic era of economic activity has been sufficiently topsy-turvy that weird
disconnects remain possible.
Consensus outlook continues to weaken
It is unsurprising but still instructive to note that the consensus economic
outlook for the U.S. economy – and for most economies – continues
to weaken. In the case of the U.S., the decline has accelerated of late, with
the 2022 and 2023 consensus GDP estimate in near free-fall (see next chart).
Our own forecasts remain below the consensus. It is also notable that the
consensus expectation for 2022 is weaker than for 2021, and that the 2023
outlook is weaker than for 2022.
U.S. consensus growth forecast continues to decline
Labour market debate
There remains a fierce debate about what to expect from the labour market as
economic activity softens. Much of this revolves around the contours of the
Beveridge Curve, which examines the relationship between job openings and
unemployment (see next chart).
U.S. Beveridge curve – job openings vs. unemployment rate
Optimists note that the level of job openings is significantly higher than
normal for the present level of unemployment. This presumably reflects
worker-employer matching problems in the economy given the many distortions
wrought by the pandemic. To the extent pandemic distortions fade and/or time
passes, these mismatches should gradually resolve. The hope is that as the
economy weakens, companies will shelve their rather extensive hiring plans
rather than lay off existing workers. This would be unusual but plausible, in
part because it would merely pull the Beveridge Curve down to its historically
normal stomping ground.
Pessimists, conversely, note that there is no precedent for job openings
falling without there also being a significant loss of actual jobs. They argue
that the natural unemployment rate appears to have increased, and so the
economy must eventually capitulate to that reality. Reducing the overheating
in the economy likely requires a multi-percentage point increase in the
unemployment rate. Furthermore, there has been a recession in the U.S. any
time the unemployment rate rises by even a small amount.
Both sides make good points. The true answer likely lands somewhere in the
middle, though our thinking is skewed somewhat toward the pessimists’
side of the equation. This is to say, the unemployment rate probably
won’t rise as much as normal, but cooling the economy likely requires a
recession and will result in significant job losses.
Canadian housing weakens
Under normal circumstances, the Canadian housing market arguably generates
more than 20% of Canadian economic output when one combines the output
produced by residential construction, renovations, realtors, real estate
lawyers, mortgage lenders, the purchase of appliances and furnishings, plus
the wealth effects normally unleashed by rising home prices.
Today, Canadian home prices are most certainly not rising, but there is some
confusion as to precisely what home prices have or haven’t done
recently.
Naturally, home prices have fallen more sharply in jurisdictions that
experienced the greatest run-up in prices beforehand. There is considerable
regional variation.
There are also wildly varying estimates at the national level. The most
exciting claim is that nationwide home prices have fallen by 17%, but this is
not an accurate estimate as it comes from an unweighted MLS metric that fails
to control for the shifting composition of home sales. If more luxury homes
are sold one year and more condos the next, it appears that home prices have
collapsed, whereas the individual price of luxury homes and condos may not
have changed at all.
At the opposite extreme are the Teranet-National Bank Home Price Index and the
New Housing Price Index. The former argues that home prices have barely fallen
(-0.3%), while the latter asserts that they are still actively rising. But
these measures also have significant flaws.
The Teranet measure only examines paired home sales – transactions for
which a particular house has been sold twice in their databank. This greatly
limits the sample size. Historically, the Teranet measure has significantly
lagged the turning points captured by more timely measures – a
significant knock against it if we want to track home price movements in a
timely way.
For its part, the New Housing Price Index completely excludes a major segment
of the housing market (condos), the land value portion of the index is
obtained quite loosely (estimated by homebuilders), and – crucially
– new homes are usually built on the outskirts of an urban area, with
each generation of new homes built further away from downtown and thus less
valuable. It is not a proper like-for-like comparison. Empirically, the index
is also extremely smooth, rarely identifying big upswings or downdrafts (see
next chart).
Housing market correction underway in Canada
Our favourite measure lands in the middle of these extreme estimates. It is
also from MLS, but calculates a benchmark price by properly controlling for
the type and size of dwelling sold. It estimates a 9.9% decline in home prices
so far (see next chart).
Run-up in home prices dwarfs the decline so far
We downgraded our Canadian home price forecast a few months ago, and are now
looking for a cumulative 20-25% peak to trough decline. That would take home
prices most of the way – but not quite all of the way – back to
pre-pandemic levels. So far, 30% of the price increase has been unwound.
U.S. student loan forgiveness?
The Biden administration announced a large executive order several weeks ago
that proposes to spend in the realm of $500 billion to cut $10,000 to $20,000
from federal student loan balances for those with less than $125,000 in
income. The order also delays student loan interest payments until 2023.
This is a significant fiscal outlay, albeit one that is spread over many years
since the cancellation of a loan results in the loss of a stream of interest
and principal payments spanning many years.
In the gripes department, this does little to address the problem of people
with huge student debts. It punishes those who sacrificed to pay off their
student loans more quickly. It represents a cash transfer to the most educated
segment of society, and it doesn’t apply to future graduates. It also
misses the most enduring solution, which would be to reduce the eye-watering
and rapidly inflating cost of a university education in the U.S. But an
executive order is not legislation, and so is limited in what it can
accomplish. Legislation is unlikely given insufficient votes in the Senate.
But we have buried the lede: there are serious doubts that the White House can
actually deliver on this promise. Significant legal challenges are expected,
and the executive order is thought by some legal scholars to be an overreach.
It is a political win for the White House, either way: they either get to
implement the policy or if it is blocked they can rally voters for the midterm
election.
One thing that will prove consequential regardless of the result of legal
challenges: those with student loans have not had to pay interest on their
loans for the duration of the pandemic. Those payments will recommence by
January. With US$1.6 trillion in student loans and, quite conservatively, a 5%
interest rate, that represents US$80 billion in additional interest payments
that will subtract from consumer spending and could cause some households
financial distress at a time of rising rates and high inflation.
Recession risk remains high
We continue to assign a 70% chance of a U.S. or Canadian recession by the end
of 2023, with an even higher risk in Europe and the U.K. It is worth
highlighting a few recent inflation signals.
The U.S. 2-year to 10-year spread has long been inverted, and now the
inflation-adjusted spread has also inverted (see next chart). It is not
classically used to gauge recessions, but arguably carries more informational
value than usual right now. It helps to strip away distortions that might
arise from the expectation embedded within nominal yields that inflation eases
over time.
Real yield curve inverted after reaching multi-year high
Meanwhile, another classic recession signal – the slope of the 3-month
yield to the 10-year yield – is now very close to inversion. In fact, it
is probably just a matter of weeks as the Federal Reserve raises rates, which
ratchets the 3-month yield higher over time. Whereas the 2-10 curve inversion
tends to lead the recession by 18 months and the peak in the S&P 500 by 15
months, the 3m-10 curve inversion tends to happen closer to those events (11
months and 10 months ahead, respectively). It should be conceded that, in our
own minds, a recession is likely to happen sooner than that and the S&P
500 peak has probably already passed.
Even though jobless claims have recently edged back downward in recent weeks,
it caught our attention that the rise in jobless claims from trough to recent
peak was – barely – enough to trigger another historical recession
signal (see next chart). The fact that jobless claims have since retreated
doesn’t invalidate the signal, as per the experience in the early 1990s
and the early 2000s. One curious thing is that, historically, the rise in
jobless claims happened well into the recession, whereas this time the
recession is still merely anticipated.
Rising U.S. initial unemployment claims are signalling recession
On a related note, we stick with the view that a Canadian recession should be
worse than in the U.S. Indeed, we recently ran an interest rate hike scenario
through our large-scale econometric model and found that, as expected, the
Canadian economy and housing market are more rate-sensitive than in the U.S.
Monetary tightening continues
Aggressive monetary tightening continues. The Bank of Canada raised rates by
another 75 basis points; the European Central Bank hiked by 75 basis points;
the Reserve Bank of Australia raised rates by 50 basis points; and the U.S.
Federal Reserve is expected to raise the fed funds rate by 75 basis points on
September 21.
The Canadian rate decision highlighted two important themes.
-
The Bank of Canada refused to celebrate despite weaker inflation in July.
The weakness was identified as being the mere result of lower gas prices,
with inflation breadth described as continuing to expand. This is factual,
though one could simultaneously argue that August inflation is likely to be
muted and that certain key inflation drivers are turning. But, for central
banks, the importance of reclaiming their inflation-fighting credentials is
such that they cannot afford to flag or claim even a smidgen of success
until total victory over inflation is assured. As such, central banks remain
likely to err on the side of tightening too much rather than too little.
-
The Bank of Canada has certainly not reached peak interest rates, but it has
probably passed the point of peak tightening. The first derivative has
turned. The central bank tightened by 100 basis points in July and by 75
basis points in September. More muted language about future actions has
convinced markets to price a 50 basis point rate increase for October,
followed by a 25 basis point hike for December. This is a steady
deceleration, conceivably landing at a 4.00% peak policy rate to ring in the
New Year.
Markets expect a similar peak policy rate of about 4% in the U.S. (see next
chart).
Expected peak fed funds rate has increased sharply
As of 08/30/22. Source: Bloomberg, RBC GAM
-With contributions from Vivien Lee, Vanessa Adams and Aaron Ma
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